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Following years of a debate centered on the arguments in favor and against the two investment styles, more professional asset managers and asset allocators are combining passive and active funds to access markets and strategies efficiently.

Nowadays, active and passive vehicles increasingly co-exist in large portfolios. They are equally used for core and satellite positions, long- and short-term targets, and across geographic exposures. Exchange-traded funds (ETFs) play a role where they offer efficiency gains, while active strategies are employed in markets where a fund manager’s acumen can provide an edge.

The smart investor

Thus, a dogmatic attitude to the active-versus-passive question has given way to a more flexible and pragmatic approach. This new investment landscape is embodied by the emerging ‘smart investor’ who employs active and passive in an opportunistic way and reaps the benefits of both.

The respective benefits of investment strategies based on either human intuition and analysis, or on systematic, rules-based approaches, have been explored and publicized at length. In some instances, due to market depth, liquidity or research coverage, an active strategy may pay off. In others, an index-based strategy may be more appropriate. Time horizon, point in the cycle and market valuation can also influence strategies’ performance.

A 2015 paper from Morgan Stanley Wealth Management used a backtested analysis to demonstrate that a dynamic and opportunistic combination of active and passive equity funds in a portfolio can yield the best returns.1 The two approaches perform differently depending on market timing and type, as well as on particular conditions such as the level of correlation between stocks, the dispersion of earnings estimates and even the shape of the US Treasury’s yield curve.

A greater breadth of capabilities

For asset managers, the shift of focus in the active-versus-passive debate has opened up new questions. The principal one among them is whether they command the full menu of strategies to service clients throughout.

In a move to keep their clients within their platform for all investments, the world’s largest active managers have reacted by adding passive offerings.

Take Fidelity International, the global asset manager founded in 1969. The renowned stockpickers introduced seven index funds in 2014, launched their first smart-beta ETFs in April 2017 and in April this year presented six low-cost cross-border equity index funds.

JPMorgan Asset Management listed its first ETF in 2014. Goldman Sachs Asset Management followed a year later, and Franklin Templeton Investments did so in 2017.

For these firms, offering passive opportunities can help compensate for the loss in active fees and provide exposure to a faster-growing market segment. It also opens up a stream of flows from a new retail client base.

Other asset managers are approaching the combination of active and passive in different ways. BlackRock, the world’s largest manager of ETFs, is investing in a significant overhaul of its active equities business. The distinctive feature in BlackRock’s plan is the focus on quantitative and computer-based strategies – or ‘systematic machine intelligence’ –, which the US asset manager has said are changing the face of active investing.2

From tactical to strategic

Professional active investors’ first foray into passive funds came with the use of ETFs for tactical portfolio adjustments and to execute short-term or tangential tasks such as hedging and liquidity management. Many of these areas were the original territory of exchange-traded derivatives.

But that quickly evolved. ETFs are now extensively employed as well in active investment decisions because of their ease of use and cost advantage, and also thanks to their ever-growing spectrum of new strategies, markets and asset classes. At the same time, actively managed strategies are more and more finding their systematic equivalent. Around half of European institutional investors use ETFs for their core portfolio exposures.3

In the US, the use of systematic strategies is even more expanded. The California State Teachers’ Retirement System (CalSTRS), the country’s second largest pension fund, has 70% of its US equities portfolio run via passive strategies. The fund employs a larger share of active strategies for its overseas equities portfolios.

Blurring the line between active and passive

The age-old debate is losing prevalence as the line between active and passive gets blurred. The emergence of passive investment vehicles where there is an active style choice, especially the extraordinary growth in factor-based or smart-beta funds, has driven this phenomenon.

For the smart investor, the black-or-white, active-versus-passive dichotomy is no longer a debate to waste time on. The energy, instead, is better spent on how to maximize benefits from both, at the same time.